Greece: Default Is Inevitable

The European Central Bank, with its staunch opposition to sovereign debt restructuring in Europe, is making a bad situation worse. By threatening to withdraw support for banks in countries such as Greece if they restructure their debts, the ECB is practically inciting runs on banks.

The argument that Greek state paper could no longer be used as collateral in such cases hardly justifies such a potentially destabilizing step. The ECB is effectively the lender of last resort to such banks. If depositors believe it is about to pull out, then they will withdraw money from the banks — and we will face a self-fuelling downward spiral.

The debt problem of peripheral Europe is structural. It cannot be solved by piling debt on debt. There is an analogy to a Ponzi scheme, under which more money is continually paid in to keep the pyramid-like edifice from collapsing. The debt/GDP ratio increases over time because new loans are given to pay old debt and to finance the remaining fiscal gaps.

In addition, the share of the debt in official hands continues to increase and eventually taxpayers bear the complete cost of the adjustment. This may, however, take time and, since the pyramid is unstable, the construction could break down at any moment — a source of increasing uncertainty.

The International Monetary Fund so far has not performed well in peripheral Europe. It was a mistake to assume that a country like Greece can re-enter the private-sector credit markets next year. This is impossible. It is even more difficult after 2013 under the perverse permanent bailout scheme where protection for private-sector creditors is progressively lowered. Programs are based on illusory “debt sustainability scenarios” that ignore that they lead to recession where countries have no chance of outgrowing their debt.

As for privatization, this is a red herring. It is useful as a short-term stopgap and for improving productivity but a fire sale of assets cannot solve the debt problem. If there is no demand for Greek debt, then there cannot be too much demand for Greek equity.

The Argentine experience during the first decade of the 21st century is instructive. So are the broader lessons of the Latin American debt restructuring in the 1980s and also that of Mexico in 1994.

Fiscal adjustment and structural reforms are crucial and necessary conditions, and privatization may play a small role, but there is no solution without debt relief, which means, without euphemisms, default. This should be nonconfrontational and as amicable as possible.

Collateralized new bonds (along the model of the Brady bonds initiative in the late 1980s) form the best procedure. This could be backed by direct liquidity and recapitalization actions for the creditor banks under similar conditions to the 2009 “Vienna model” successfully used for central and eastern Europe.

However, without significant write-downs of existing debt, there is no way out.

Contrary to the ECB’s stated view, it is easier to regain credit market access after a significant reduction of the debt burden, as both Uruguay and Argentina showed. The latter did not handle the matter well until 2005 but corporations were soon back in the market. Today, while the issue is not fully resolved, Argentine borrowers can borrow at half the spread paid by Greece.

With regard to the fear of contagion to other countries, explicit debt relief for the most-badly hit EMU members may actually relieve the pressure on Spain and others — as long as the money used today to pay bondholders is channeled directly to recapitalize and sanitize the banking system.

Regarding the ECB’s opposition, I am convinced that the question is not whether but when the ECB will do a U-turn (as it did with purchasing bonds in the secondary markets in May 2010).

There is a good argument for taking necessary decisions on debt restructuring sooner rather than later. Further “muddling through” is a recipe for disaster. Unless a proper program of coordination and adjustment combined with debt relief is decided soon, Europe faces the risk of becoming the next emerging market.

by Mario Blejer
Friday, June 10, 2011
Mario Blejer was president of the Central Bank of Argentina, and has held top positions at the International Monetary Fund, the World Bank and the Bank of England. This article originally appeared in the Bulletin of the Official Monetary and Financial Institutions Forum.